CHAPTER TWO

THE DEMAND FOR AND THE SUPPLY OF MONEY

2.1. The Demand for money

This concept represents the amount of money demanded by a given community at a particular
period of time. There are two distinct approaches to the concept of demand for money: the
Classical approach and the Keynesian approach.

The Demand for money

The Classical Approach The Keynesian Approach

Fisher Marshall/Pigou J.M. Keynes

1. The Classical Approach

According to this approach, money is demanded because it serves some purposes. Money has
two purposes or functions.
i. Money acts as a medium of exchange (which is very much stressed by classical
economists)
ii. Money serves as a store of value.

They argued that; people demand money for transaction purposes. That means money is not
required for its own stake but to pay for goods and services and to carry out the economic
transactions over a period of time. They thought that the demand for money was determined by
the total quantity of goods and services that had to be paid for during a given period and on the
velocity of circulation of money. There are two distinct views under the classical analysis: The

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fisherian view/The transactions balance version; The Cambridge economists view/the cash
balance version.

A. The Fisherian View/Approach

It is also referred as the Transactions-Balance version. The demand for money relates to the
amount of money people “have to hold” to undertake a given volume of transactions over a
period of time. Thus, the demand for money is determined by three objective factors.
 the volume of transactions
 the average price level per unit of transaction, and
 the average velocity of circulation of money

The promoter of this idea, professor Irving Fisher develop a formalistic expression to this
approach in his equation of exchange, also known as the cash-transactions question: MV = PT.
where: M = stock of money
V = velocity of circulation
P = price level, and
T = volume of transactions

Velocity (V) refers to the rate at which money circulated. It is measured as the average number
of times a unit of money changes hands during a year.

B. The Cambridge View/Approach

It is also referred as the cash-balances version. It is developed by Marshall and Pigou. This
version stresses on money as a store of value not as a medium of exchange like the Fisherian
approach. The total demand for money in the community is, thus, measured by aggregating the
individual’s demand to hold cash balance. The Cambridge approach analyzed the demand for
money according to the choice determined behavior of the people and recognized many factors.
Such as:
i. Interest rates
ii. Wealth possessed by the individuals
iii. Purchasing power of money, that provides the services of conveniences as well as
security to its holders.

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 iv. Expectations about future changes in the prices and interest rates tend to affect
individual’s decisions.

The approach has an assumption that during short period, these factors remain constant or
proportional to changes in the level of income. Therefore, the total demand for money or cash-
balances is the proportion of the nominal national income. They develop the following formula
to express their assumption. Md = Kpy
where MD = the demand for money
K = the proportionality factor: - It refers to the proportion of national income that the
people desire to keep in the form of nominal money balances (cash balances)
py = the nominal national income

Therefore, as the nominal national income remains constant the change in the proportionality
factor will change the demand for money. i.e., as the proportionality factor increases the demand
for money also increases and vice versa.

Assume that the nominal national income is Br. 1, 000, 000.00 and the proportionality factor is
10%. Then, the demand for money will be calculated as follows.

Md = Kpy

10
Md = 100 x 1,000,000.00

Md = 100,000.00

As the proportionality factor increases to 20%, while the nominal national income remains
constant, the demand for money will be:

20
Md = 100 x 1,000,000.00

Md = 200,000.00

and the reverse will be true if the proportionality factor decreases to 5%

5
Md = 100 x 1,000,000.00

3
 Md = 50, 000.00

2. The Keynesian Approach

It is also referred as the cash balance or liquidity preference approach. It is developed by John
Maynard Keynes and those who follow his approach are referred as Keynesians. This concept is
associated with the Keynesian analysis of the demand for money. It is an extension of the
Cambridge economists-view-the cash-balances approach and stresses the asset role (i.e., the store
of value function) of money. To Keynes-demand for money does not mean the actual money
balances held by the people, but what amount of money balances they want to hold.

Money is not just meant for spending but to hold. Money can be held as a form of wealth or
asset, as the most liquid asset which is readily used for payment in the exchange process. Hence,
money being the most liquid asset, can serve as an efficient store of value; so it is demanded for
its own sake. In this sense, the demand for money is the inverse of the velocity of circulation.
Velocity of circulation refers to the rate of changing hands through spending but the liquidity
preference is a store of value.

Therefore, the demand for money, in the Keynesian sense, is a demand for liquidity or “liquidity
preference”. Hence, the modern approach is designated as the cash balance or liquidity
preference approach.

Keynes distinguished three motives which induce people to hold money. They are: the
transaction motive, the precautionary motive and the speculative motive. Corresponding to these
motives, Keynes separated the demand for money into three parts as: the transaction demand, the
precautionary demand and the speculative demand for money. The total demand for money,
hence, implies total cash balances. Total cash balances can be classified in to two parts as the
active cash balance and idle cash balance.

Active cash balances

It is related with the demand for money held under transactions motives demand and
precautionary motive/demand for money.

i. Transactions demand for money

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 This is related with the primary functions of money – as a medium of exchange. Individuals
do not receive money income as frequently as they make payments. Thus, when income is
received at discrete intervals of time, but is paid out more or less continuously against the
exchange of goods and services, it is inevitable that people should need a certain stock of
money all the time in order to carry out their transactions.

Keynes defines the transaction demand for money as “the need of cash for the current
transactions of personal and business expenditure”. Personal expenditure referred as income
motive and the business expenditure as business motive.

The Income Motive

Consumers hold money balances to facilitate their day-to-day purchases of consumption
goods. By keeping cash-balances they tend to bridge the gap of time interval between
receipts of incomes and its disbursement. The consumer’s / individual’s demand for money,
depends upon the following factors.

a) The level of income: -The rich man tends to hold more money balances for transactions
purposes than the poor does.
b) The Price level: -During inflation or as price rises, the consumer’s transactions demand
for money tends to rise, corresponding to the rising price level. The higher the price, the
lower the purchasing power of money will be. Hence, to fulfill the daily transaction
requirements more money is required by the consumer.
c) The spending habits: -A spend thrift need more transactions demand for money than a
saver does.
d) The time-interval: -The time-gap involved between the receipts of successive income
flows and the corresponding expenditure. As the time gap increases, more money is
demanded to spend throughout that time period than when the time gap is short. You can
take yourself as an example. You are receiving your salary every month. You need a
certain sum of money to spend it throughout that period. But, instead assume that your
payment is made every two months not every month. Now you need more money to
spend throughout the two months time than you were demanding to spend in a month
time.

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The Business Motive
This refers to the transactions motive to the entrepreneur class or business community.
Business persons require money balances in order to meet business expenses. Money
balances held under this motive will depend on the turnover of the firm. The larger the
turnover, the larger will be the demand for money. Thus, the amount of money balances held
under the transactions motive will depend on the time and size of the firm’s incomes, and the
turnover of business.

For example, money demanded for the transactions motive will rise as income of the firm
increases, during business prosperous, festive seasons, vacation periods busy seasons and
after harvest. Money demanded for the transactions motive declines in the slack season.

The trends of a community’s aggregate demand for money, under the transactions motive,
depicts a high degree of correlation of proportionality to the size of money of national
income which can be represented as Lt = f(y)

where L – the transactions demand for money, and

y = the level of national income.

Hence, as national income increases, the transactions demand for money will increases and vice
versa.

ii. Precautionary Demand for money

People generally desire to hold some additional money balances against unforeseen

contingencies. They keep some liquid reserves or cash balances to provide for unexpected

contingencies such as illness, accidents unemployment some ceremonial occasions, etc. The

amount of money demanded here will be devoted to fulfill the functions of a store of value.

The precautionary demand for money depends largely on the uncertainty of future receipts

and expenditures. It is sensitive to the anticipation of the level of income and hence it is

income-determined and is relatively stable. As income increases the cash balance set aside

for precautionary purpose also increases. It can be depicted with a formula as follows

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 Lp = f(y) where : - Lp = precautionary demand for money

y = national income

Finally, the demand for active cash balances (transaction demand for money and

precautionary demand for money) is a function of income. It will rise as income level

increases and decrease as income decline.

LA = Lt + Lp  LA = f(y)

where LA = Active cash balance

Lt = Transaction demand for money

Lp = precautionary demand for money

y = national income

y
LA
Demand for money

(Lt + Lp)

A
x
0 y1 y2

When income levelIncome

is 0y1; the demand for money will be 0A, and when income level

becomes 0y2, the demand for money will be 0B. This shows that the transactions and

precautionary demand for money are income determined, more or less interest inelastic and

relatively a stable phenomenon.

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iii. Idle cash balances / the speculative demand for money

The speculative demand for money represents the demand for cash for being invested rapidly
as and when attractive opportunities for monetary investments appear.

The speculative money, in fact, confines itself to the store of value property of money.
Money held under the speculative motive constitutes a store of value, a liquid asset, which
the holder intends to use for gambling or to make a speculative gain, example, investment in
securities at an opportune moment.

In holding the active cash balances, the main consideration was convenience, and
prudence/showing carefulness and foresight, avoiding rashness. But it has least consideration for
the rate of interest. Whereas, holding of idle cash balances, much attention is paid to the rate of
interest because these balances are held for income earning purposes of speculative activity. The
amount of money held under speculative motive depends upon the rate of interest. When people
expect interest rate rises and the prices of fixed income-yielding assets, like bonds, to fall, more
balances will be held in cash. Then the idle cash balance will be invested in the future in such
instruments that attract higher income than investing on such instruments with lower prevailing
interest rate. If people expect the rate of interest to fall and prices of bonds to rise, there will be
an increased tendency to hold bonds, and other near-money assets than cash. In this assumption,
the rate of interest at present is greater than the future expected rate of interest; hence, its income
at present is higher than its income in the future. Thus, the speculative demand for money will be
less. In other words, at the time rates of interest is low, people prefer to hoard their money rather
than use it to buy securities and vice versa. Thus, the bond or securities price and interest rates
always move in opposite directions.

Total Demand for Money

The community’s total demand for money depends on the transaction and precautionary motives
and the speculative motive. In other words, it is equivalent to the active cash balances (L 1) plus
the idle cash balances (L2).

L = L 1 + L2

where: L = stands for an overall demand for money (Active + Idle balance)

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 L1 = f(x)

L2 = f(I)

L = f(x, I)

This means that the community’s overall demand for money depends upon the level of national
income and the rate of interest.

2.2. The Supply of Money

Money supply refers to the amount of money which is in circulation in an economy at any given
time. In a broader sense, money supply refers to the total stock of domestic means of payment
which is held by the public. The public refers to individuals, business firms, state and local
government bodies, etc. other than state treasury, central bank and commercial banks which are
referred as being money creating agencies. It is also known as money stock or stock of money or
quantity of money.

Money supply has two different concepts: stock and flow concepts. In its stock concept, money
supply is viewed at a point of time and it refers to the total of currency notes, coins and demand
deposits. Whereas, in its flow concept; money supply is viewed over a period of time. It is
money spendable as well as re-spendable. It is associated with the velocity of circulation of
money. The Fisher’s MV represents the flow of money supply over a period of time.

There are three alternative views regarding the definition or measures of money supply. They
are:

1. The Traditional Approach (M1)

This definition of money supply includes any asset (cash, traveler’s checks, and checkable
deposits of depository institutions) that is a generally acceptable medium of exchange. This
definition is a narrower definition and stresses the medium of exchange function of money. The
money supply is composed of:
a) Currency money and legal tenders i.e., coins and currency notes in the hand of the public.
This is referred as high-powered money.
b) Demand deposits and other checking accounts that allow unlimited transfer of funds from
one financial institution to another. Such as checkable deposits at commercial banks,

9
 checkable deposits at credit unions and thrift institutions, and traveler’s checks
outstanding. It is referred as secondary money.
2. Modern Definition (M2)
The M2 money supply emphasizes the role that money plays as a “store of value”. Thus, it
includes both savings accounts in which customers may store idle cash to earn interest before
they spend it and the M1 money supply that can be spent immediately. In other words, M2
includes M1 + non checkable savings accounts and time deposits at depository institutions.

3. The Modern approach (M3)

It includes M2 plus deposits at non-banking financial institutions, and near-money assets. It is
the broadest definition of money supply.

Determinants of Money Supply

The major determinants of the quantity of money in an economy are:

1. Extent of Monetization
Monetization refers to the use of money in the system of exchange in an economy. A barter
economy is a non-monetized economy. A fully monetized economy needs more money supply
than a partially monetized economy of the same order.

2. Cash Reserve Ratio

This refers to the ratio of bank’s cash holdings to its total deposit liabilities. It is customarily or
statutory fixed by the central bank. It is also referred as required reserve ratio or reserve deposit
ratio. As cash reserve ratio increases the reserve amount increases and the excess reserve
decrease. The excess reserve is the basis for credit creation of a banker. Hence, as excess reserve
decreases the credit creation capacity of the bank and the money supply decreases and vice versa.
The excess reserves are important for the determination of the money supply. The excess reserve
is influenced through: open market operations and the discount rate policy.

a) Open market operations

Open market operations refers to the buying and selling of securities in the money and capital
markets – (this will be discussed in the future in this same material). When central bank sells
securities in the open market the buyer of the security pays with cheques drawn on a specific
banker. Therefore, the level of the bank’s reserve will contract. In other way, when central bank

10
purchases securities in the open market, it pay’s with cheques drawn on commercial banks. This
expands the level of bank reserves.

b) The Discount rate policy

High discount rate means that commercial banks get fewer amounts by selling to the central
bank. The commercial banks, in turn, raise their lending rates to the public thereby making
advances dearer for them. As the rate raise, customers will be reluctant to borrow at a higher rate.
Thus, there will be contraction of credit and the level of commercial bank reserves. The opposite
is the case when the bank rate is lowered.
Discount rate  cost of credit credit in commercial bank reserves
Discount rate  cost of credit  credit  in commercial bank reserves

3. Government budgetary policy of monetary financing

The government can borrow from the banking and non-banking sources. When government
borrows’ directly from the non-banking sources (the public) it pumps out money from the public
and money supply with the public may shrink initially, but when spent by the government money
pumped into the public and the money supply will increase again. When the government restores
to the banking sector and borrows from the banking system to spend it leads to a creation of
demand deposits in favor of the government treasury in exchange for government securities. The
net central bank credit to the government is termed as deficit financing.

4. Public’s desire to hold currency and deposits

People’s desire to hold currency (or cash) relative to deposits in commercial banks also
determines the money supply. If people are in the habit of keeping less in cash and more in
deposits with the commercial banks, the money supply will be large. This is because banks can
create more money with larger deposits. On the contrary, if people do not have banking habits
and prefers to keep their money holdings in cash, credit creation by banks will be less and the
money supply will be at a low level. High-powered money is the sum of commercial bank
reserves and currency (notes and coins) held by the public. High-powered money is the base for
the expansion of bank deposits and creation of the money supply.

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5. Other factors
The money supply is a function not only of the high-powered money determined by the
monetary authorities, but of interest rates, income and other factors. The latter factors change the
proportion of money balances that the public holds as cash. Changes in business activity can
change the behavior of banks and the public and thus affect the money supply.

2.3. Velocity of money

Velocity of money is a number of times a unit of money changes hands through buying process.
Money’s velocity or rapidity of circulation is one of the direct determinants of the volume of
expenditures and therefore of the value of money. In fact, in many periods velocity fluctuates
more widely than does the quantity of money, and sometimes much more widely than does the
quantity of money.

As noted earlier, two of the functions of money are those acting as a medium of exchange and as
a store of value. Therefore, each receiver of money immediately spent it all for goods, services
and securities that is, used it immediately, as a medium of exchange the velocity of money would
be almost infinitely great. But this rarely occurs. Though the receiver of money may dispose of it
immediately, he may also hold some or even all of it as a store of value for a given period of time
known as savings. The longer this “average interval of rest” between receipt and expenditure, the
lower is its velocity of circulation. Thus, anything that affects peoples decisions regarding the
length of time that they will hold money before passing it along influences its velocity.

Determinants of the Velocity of Money

1. The stage of development of credit and financial system and the extent to which the
community uses it
 Ease of lending and spending.
 Ease of borrowing.
2. The habits of the community as to saving and consumption
3. The system of payments in the community.
 As to frequency of receipts and disbursements
 As to regularity of receipts and disbursements.
 As to correspondence between times and amounts of receipts and disbursements.

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 4. The rapidity of transportation of money.
5. The state of expectation or anticipation of the community.
 As to amounts of future income and prices of goods and services.
 As to movements of the prices of income yielding assets.

The rapidity of circulation of money is greatly influenced by the state of development of the
credit and financial system and by the community’s readiness to use these facilities. If a
community is without a well-developed and widely used credit system, the velocity of the money
is likely to be affected by the people’s habits as to savings and consumption. Velocity is also
affected by the system of payments used in the community. By this is meant the frequency,
regularity, and correspondence between time and amounts of money receipts and disbursements.
The greater the frequency of receipts and disbursement of money and the higher is its average
velocity.

Also the members of the community come to feel that incomes will be received more regularly
and in increasing amounts and that prices probably rise, the velocity of money is likely to be
increased. The situation is reversed when large section of the society come to feel that incomes
and prices will not rise and that they are likely to fall. Such anticipations may be traceable to
fears of one or more of many things, such as a decrease in money supply, loss of foreign markets
for local goods, a stock market crash, unfavorable laws of the country, labor disputes etc. Under
such conditions consumers postpone purchases of consumption goods, in so far as that is feasible
or affordable, in order to take advantage of the expected lower prices later and to protect
themselves against want during threatened rainy days. Enterprisers also tend to postpone
purchases of capital equipment and raw materials for the same reasons tend because prospective
profits from production are not sufficiently encouraging.

2.4. Value of Money

By the value of money is meant the purchasing power of money over goods and services in the
country. What a birr can buy in Ethiopia represent the value of money of the birr. Thus, the
phrase, “value of money” is a relative concept which expresses the relationship between a unit of
money and the goods and services which can be purchased with it. This shows that the value of
money is related to the price level because goods and services are purchased with a money unit
at a given prices. But the relation between the value of money and price level is an inverse one.
13
If V presents the value of money and P the price level, then, V=1/P. when the price level rises,
the value of money falls, and vice versa. Thus in order to measure the value of money, we have
to find out the general price level. The value of money is of two types: the internal value of
money and the external value of money. The internal value of money refers to the purchasing
power of money over domestic goods and services. The external value of money refers to the
purchasing power of money over the foreign goods and service.

2.5. Measurement of Changes in the Value of Money or in Prices

Economists and the public are concerned about whether prices are rising or falling and by how
much it vary. Changes in prices tell something about the cost of living and what is happening to
the purchasing power of money. Changes in the general level of prices are the easiest to measure
by converting individual price changes into a price index.
index.

Price Index
A price index is “a figure showing the height of average prices at one time relative to their height
at some other time that is taken as the base period” professor Chandler. To understand the term
index number, note the following three points.
1. An average figure relates to a single /representative group of commodities.
2. It measures the net increase or decrease of the average prices for the group under study.
3. It measures the extent of changes in the value of money /or price level/ over period of
time, given a base period.

Illustration
Simple price index
Price in the Base Base period Prices in 1994 Price
No Commodities period (1970) p2 Index (p1) Relatives (R)
1 Wheat Br. 90/Qt 100 Br. 150/Qt 166
2 Teff Br. 130/Qt 100 Br. 300/Qt 230
3 Cloth Br. 10/Mt 100 Br. 30/mt 300
4 Edible oil Br. 6/Kg 100 Br. 12/kg 200
5 Milk Br. 0.70/Lit 100 Br. 1.25/lit 178
6 House Rent Br. 50/month 100 Br. 200/month 400

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 R = 1474
Price in 1994 P
 100 or 1  100
* Price Relative (R) = Price in 1970 P2

 R  1474 / 6
Price Index in 1994 = N = 245.67
This indicates that price in 1994 increases by 145.67 percent than the base year (1970)
Pt  Pt  1
 100
or p = Pt  1
245.67  100
 100
p = 100

p = 145.67
Weighted Price Index
Weight Price in the Base Base period Price WXR
No Commodities W period 1970 index Price in 1994 relative
1 Wheat 4 Br. 90/Qt 100 Br. 150/Qt 166 664
2 Teff 8 Br. 130/Qt 100 Br. 300/Qt 230 1840
3 Cloth 6 Br. 10/ Mt 100 Br. 30/mt 300 1800
4 Edible oil 5 Br. 6/kg 100 Br. 12/kg 200 1000
5 Milk 3 Br. 0.70/Lt 100 Br. 1.25/lt 178 534
6 House Rent 7 Br. 50/month 100 Br. 200/month 400 2800
W = 33 WR = 8638

WR 8638
Using arithmetic mean, the weight price index in 1994 = 
W
= 33 = 261.76
The weighted price index shows an increase of 161.76 percent in the price level in 1994 over
1970 as against the increase of 145.67 percent according to the simple price index.

Methods of construction of index numbers

In constructing an index number, the following steps should be noted.
1. Purpose of the Index number

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Before constructing an index number, it should be decided the purpose for which it is needed. An
index number constructed for one category or purpose cannot be used for others because the
variables included might be different.
2. Selection of the base period
It is the most important step in the construction of an index number. It is a period against which
comparisons are made. It should be normal and free from an unusual event such as war, famine,
earthquake, drought, boon, etc. It should not be very recent or remote.
3. Selection of number and kinds of commodities
The number and kinds of commodities to be selected depend up on the purpose or objective of
the index number to be constructed. If the purpose of the index number is to measure the changes
in the general purchasing power of money then, we should select samples which are
representative of the inverse they intend to describe. If we want to study the industrial workers
cost of living, we must select only those goods and services which dominate industrial workers’
consumption budget, namely wage goods. In this regard, different individuals have
recommended the right size and commodities to be included in the index.
4. Listing of Prices of Commodities
After the base year and number of commodities having been decided, the next step is to list
prices of all the commodities in question in the base period year. We have to determine which to
use: the wholesale or retail prices. Prices should be obtained from reliable sources for the
purpose; otherwise, it will be a misleading conclusion. It can be gathered from representative
persons, places or journals or other sources.
5. Averaging

Difficulties in the Construction of Index Numbers

There are many difficulties in the construction of index numbers. They are:
1. Difficulties in the selection of the base period
The base year should be normal. But it is difficult to determine a truly normal year. Moreover,
what may be the normal year today may become an abnormal year after some period.
2. Difficulties in the selection of commodities
On account of changes in tastes and habits of the people during the base year and this year, it is
difficult to select commodities as a reference of study. In addition, at the same time different
classes of the society consumes different types of commodities and their possession is quite
16
different. Moreover, many new commodities non-existence in the base year may appear on the
scene in this year and may dominate the consumption list of the workers. Or commodities which
were highly consumed during the base year may no more be in use in this year. Therefore, both
commodities must be excluded in the study.
3. Difficulties arising from changes overtime
Due to technological change, changes in the nature of commodities are taking place continuously
overtime. Hence, new commodities are introduced and people start consuming them in place of
the old ones. These commodities must be excluded form the index.
4. Difficulties in the collection of prices
It is often not possible to get adequate and accurate prices from the same source or place.
Further, the problem of choice between wholesale and retail prices arises. The wholesale prices
are better than the retail prices because the retail prices are very variable.
5. Arbitrary assigning of weights
The problem is to give different weights to commodities. The selection of higher weights for one
commodity and a lower weight for another is simply arbitrary. Moreover, the same commodity
may have different importance to different consumers. The importance of commodities also
changes with the change in the tastes and incomes of consumers and also with the passage of
time.
6. Difficulty of selecting the method of Average
There are a number of methods which can be used for this purpose. But all methods give
different results from one another.
7. No All purpose index number
There are no all-purpose index numbers. An index number constructed for a particular purpose
cannot be used for some other purpose. Therefore we are forced to prepare different index
numbers for different purposes.
8. International comparisons are not possible
The commodities consumed and included in the construction of an index number differ from
country to country. Similarly,
Similarly, weights assigned to commodities at different countries are also
different. Because of that we cannot compare the domestic price with the international price
level.
9. Comparisons of different places are not possible

17
Even if different places within a country are taken, it is not possible to apply the same index
number to them. This is because of differences in the consumption habits of people. People
living at different regions consume different commodities.
10. Not applicable at an individual
If an index number shows a rise in the price level, an individual may not be affected by it. This is
because an index number reflects averages. Therefore, an index number is not applicable to an
individual belonging to a group of which it is constructed.

2.6. Monetary Standard

Monetary standard refers to the overall set of laws and practices which control the quality and
quantity of money in a country. It is, in fact, the standard money of the country which determines
and regulates the exchange value of goods and services. Thus, the monetary standard of a nation
is its standard monetary unit. If, for instance, the standard monetary unit is made of silver, the
country is said to be on the silver standard. There have been different types of monetary
standards in the evolution of money. But only two types of monetary standards have been
popular with nations in the recent past. They are:
1. Metallic or commodity standard:- it refers to a monetary system in which the value of the
monetary unit is expressed in terms of a fixed quantity of some metal. If the monetary
system is related to only one metal, it is known as Monometallism. Monometallism may
refer to the gold standard if the metal is gold and to silver standard if the metal is silver. If
the monetary unit is made of two metals, the monetary standard is called bimetallism.
2. Paper or fiat standard:- in this standard, paper notes circulate as legal tender money. They
may be convertible into the metal, gold or silver, of a fixed weight, or convertible.

The Gold Standard

The gold standard is a monometallic standard in which the value of the monetary unit is fixed in
terms of a specified weight and purity.

Types of the Gold Standard

The meaning of the gold standard, as given above, relates to its general form. But different
countries at different times adopted different types of gold standard which are explained as
under.

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1. Gold Currency Standard
It was also known as the gold coin standard, gold circulation standard or full or pure gold
standard.
-gold coins of a definite weight and fineness circulated within the country

-the gold coin was full and unlimited legal tender

-non-gold metallic coins and paper currency notes also circulated side by side but they
were convertible on demand into gold coins at fixed rates.

-there was free coinage in gold

-gold coins could be freely minted for other purposes

-export and import of gold were free and unrestricted

Since this standard was costly to operate, it was given up after the First World War in favor of
the gold bullion standard.

2. Gold Bullion Standard

-gold coins did not circulate within the country. The legal tender currency in circulation
consisted of paper currency notes and token coins of silver and other metals.

-these were convertible at fixed rates into gold bars or bullion.

-for converting currency into gold, the monetary authority was required to keep gold bars
in reserve

The monetary authority also bought gold from the public at fixed price

-gold was freely exported and imported

3. Gold Exchange Standard

-gold coins did not circulate within the country

-the currency consisted of paper notes and token coins of silver and other metals

-these were not convertible into gold coins or bullion

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 -but the local currency was linked with some foreign currency which was on gold
currency standard

-it was convertible into such foreign currency at a fixed rate

-since the currency was indirectly linked with gold, prices of goods and services were
consequently determined by the prices of gold

- Gold could not be exported and imported freely

4. Gold Reserve Standard:- England was the first country to abandon the gold standard in
1931, followed by the USA in 1933 and France in 1936. This led to instability in their exchange
rates. To maintain exchange stability, they entered into Tripartite Monetary Agreement in
September 1936 and they were joined by the Netherlands, Belgium and Switzerland in the same
year. This agreement came to be known as the Gold Reserve Standard and worked successfully
till the outbreak of the Second World War in September 1939.

-there were no gold coins within the country

-the currency consisted of paper notes and token coins of cheap metals

-this currency was inconvertible into bullion

-under the agreement, each country maintained an Exchange Equalization Fund which
kept gold, local currency and foreign exchange. The exchange rate was stabilized by
purchase and sale of foreign exchange or gold from the fund.

-there was no free export or import of gold except by the Fund authority for maintaining
stability in the exchange rate. Such gold was meant to be kept in the fund.

-there was strict secrecy about the reserves of gold and foreign exchange kept in the Fund

5. Gold Parity Standard

This system has emerged with the establishment of the International Monetary Fund in 1944. It
does not possess any feature of the various gold standards explained above. Under this system,
every country has to declare the par value of its monetary unit in terms of a fixed quantity of

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gold. So this is not gold standard in the real sense of the term, except that it aims at keeping the
exchange rate of the currency stable in terms of gold.

Bimetallism
It, also known as bimetallic standard, is a monetary system under which the monetary unit of the
country is expressed by law in terms of two metals, usually gold and silver, in specific ratio. In
other words, under bimetallism both silver and gold coins circulate simultaneously within the
country. They are unlimited legal tender. They are minted freely and in unlimited quantities free
or with some charge. Both metals are imported and exported freely. Both types of coins are
exchanged for each other at a fixed mint par ratio.

Paper currency standard

Paper currency standard consists of paper money which is unlimited legal tender and token coins
of cheap metals. Paper money may be either convertible or inconvertible. Convertible paper
money is convertible into gold or silver coins or bullion of specified weight on demand. Paper
money is not convertible into coins of a precious metal of bullion now-a-days. Therefore, it is
inconvertible. People accept it because it is legal tender. Since it has the command of the
government, people have to accept it. That is why it is also known as fait money or standard. It is
also referred to as managed standard because the issue of paper money and token coins is
managed by central bank of the country.

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